Our subprime monetary system

Published: April 11, 2008

For millennia, “money” was gold or silver. The U.S. dollar was originally 1/20th of an ounce of gold, before the creation of the Federal Reserve in 1913. The dollar traded recently at around 1/1000th an ounce of gold. So, for now, the dollar retains 2 percent of its worth, but there is no mechanism for maintaining any set value. The difference between the U.S. currency and the Zimbabwe dollar depends entirely on what buttons are pressed on Ben Bernanke’s computer.
Critics of the instability of the Federal Reserve tend to focus on the fact that dollars have no intrinsic value. But dollars have value because you can give them to the IRS in lieu of your jewelry, house, children, etc. Until the IRS starts demanding payment in gold or Swiss francs, dollars have a captive market.
But the Federal Reserve does have an irreparable character flaw worthy of a Greek tragedy: it is a fractional-reserve system. In other words, banks within the Fed system are allowed to lend many times more dollars than they actually have. Every dollar that goes into a bank thus creates 10 or more new dollars. Conversely, when you take a dollar out of a bank and reduce its reserves, you destroy those created dollars. So the quantity of Fed notes can fluctuate wildly, disrupting the information flow that is the basis of our market economy.
For instance, (totally hypothetically, of course), if a bank were forced to reveal that its “reserves” consisted of worthless subprime mortgage securities, it could no longer issue loans based on these “reserves,” and the money supply would fall. Then, when the Fed prints money or Treasury securities and gives them to the banks in exchange for the worthless subprime paper, the money supply would go back up. (Of course there is an effect on the ownership of the money supply, in that now the worthless securities are owned by the taxpayer, and the new money by the bank).
The quantity of dollars fell by about 30 percent before the Great Depression. Since then, the money supply has varied according to the Fed’s whims, generally upward as it prints money to pay for government programs, but with occasional dips.
If this fractional-reserve aspect of the Federal Reserve were removed, it would be only a short step to a fully transparent monetary system. The justification of the current secrecy and Fedspeak mumbo-jumbo is that the whole system is so unstable that it will collapse if the public gets a clear look at it in the light of day. Replacing the Fed with a Currency Board would remove the whole issue of instability.
Under a currency board, there would be no surprise inflations or deflations. The supply of money could be either permanently fixed, or made to grow at a set percentage, or pegged to the price of a basket of commodities, or actually backed by a basket of commodities. Foreign holders couldn’t be spooked into dumping all their dollars at once into any panic.
Money could once again flow steadily through the nerves of the market economy, transmitting accurate price signals about what to produce or consume. There would be no more financial bubbles, no more cycles of overproduction and underproduction, misemployment and unemployment.
A currency board that issued the dollars in a 100 percent-reserve system wouldn’t have to be staffed with political appointees — it wouldn’t even have to be a part of the government. Given the sorry historical record of politicians with paper money, probably it shouldn’t be. Religious wars became rare in civilized nations once we separated church and state. A similar happy result could follow from separation of money and state.
Bill Walker is a resident of Grafton.

This article appears in the April 11 2008 issue of New Hampshire Business Review